Mutual Funds
Mutual funds are the most common type of pooled investment. They come in two main forms: open-end (traditional mutual funds) and closed-end funds.
The Investment Company Act of 1940
This federal law (commonly called the ICA) governs how investment companies operate and classifies them into three statutory types under Section 4:
| Category | What It Does | Portfolio Changes? |
|---|---|---|
| Face-Amount Certificate (FAC) | Promises to pay a set amount on a future date | N/A (obsolete) |
| Management Company | Professionals select and trade securities | Yes (active) |
| Unit Investment Trust (UIT) | Holds a fixed basket of securities until maturity | No (static) |
Face-amount certificates are obsolete. Open-end and closed-end funds are management companies. Private funds (hedge funds, private equity, venture capital) avoid ICA registration via Section 3(c)(1) or Section 3(c)(7) exemptions.
Open-End Investment Companies (Mutual Funds)
Open-end funds continuously issue and redeem shares. There is no fixed number of shares outstanding. Shares are created on purchase and retired on redemption.
How they work:
- Investors buy and redeem directly with the fund (no secondary market trading)
- Purchased at the public offering price (POP) = net asset value (NAV) + sales charge
- Redeemed at NAV
- Cannot be purchased on margin or sold short
- Sold by prospectus (summary or statutory)
- Fund must redeem shares within 7 calendar days
- Must register with the SEC under the ICA
- Board of directors oversees the fund (including independent/non-interested directors)
- Classified as diversified or non-diversified under ICA Section 5
Net Asset Value (NAV):
- Calculated once daily after markets close (4:00 PM ET)
- Forward pricing - orders received before 4:00 PM ET get that day's NAV; orders received after get next day's NAV
Exam Tip: Gotchas
- Open-end fund shares are NEVER traded on an exchange. They are bought from and redeemed directly with the fund company. If a question describes shares trading at a premium or discount to NAV, it is NOT an open-end fund.
Closed-End Investment Companies
Closed-end funds issue a fixed number of shares through an IPO. After the IPO, no new shares are created.
How they work:
- After IPO, shares trade on exchanges (NYSE, Nasdaq) like stocks
- Do NOT redeem shares - investors buy/sell on the secondary market
- Can trade at a premium (above NAV) or discount (below NAV)
- Market price determined by supply and demand, not just NAV
- Can use leverage (borrow money, issue preferred shares, or issue debt)
- Can be purchased on margin and sold short
- Priced continuously throughout the trading day
Open-End vs Closed-End Comparison
| Feature | Open-End (Mutual Fund) | Closed-End Fund |
|---|---|---|
| Shares outstanding | Variable (unlimited) | Fixed |
| Pricing | NAV (once daily, forward pricing) | Market price (continuous, exchange-traded) |
| Buy/sell | From/to the fund company | On an exchange (secondary market) |
| Premium/discount | Always at NAV (+ sales charge) | Can trade above or below NAV |
| Leverage | Not permitted | Permitted |
| Margin/short selling | Not permitted | Permitted |
| Redemption | Fund redeems within 7 days | No redemption; sell on exchange |
| IPO | Continuous offering | One-time IPO |
Exam Tip: Gotchas
- Closed-end funds commonly trade at a DISCOUNT to NAV. When the exam describes a fund trading at 95% of NAV, think closed-end fund (or ETF in rare cases). Open-end funds always transact at NAV.
Interval Funds
Interval funds are legally classified as closed-end funds under the ICA but do not trade on an exchange. They bridge the gap between daily-redeemable mutual funds and fully illiquid private funds.
- Periodically offer to repurchase shares directly from investors (typically quarterly)
- Repurchase amount: 5% to 25% of outstanding shares per offer
- If redemption requests exceed the offer, repurchases are made pro rata
- May charge a repurchase fee of up to 2% of proceeds
- Invest in less liquid assets (private credit, real estate, private equity-like strategies)
- Priced at NAV for repurchase offers
Think of it this way: Interval funds say: "We cannot let you sell every day because we own hard-to-sell assets. But every few months, we will buy back some shares so you are not completely stuck."
Exam Tip: Gotchas
- Interval funds provide LIMITED liquidity - not daily like mutual funds, not zero like private funds. They sit between open-end funds and fully illiquid private funds.
- Pro rata redemption: If too many shareholders want out, each gets only a portion redeemed.